Equities slump drags down metals prices

July 29-Aug. 2 at a Glance

– Copper prices were heavily oversold and funds were close to their limits on the short side. Consequently, support at US$1,495-1,500 per tonne should hold, though upside potential is limited.

– Aluminum prices garnered support from an encouraging volume of European forward buying, and the US$1,300-per-tonne level should hold for the short term. However, rapid growth in supply suggests prices may then move even lower.

– Nickel prices proved more resilient than the rest of the base metals complex, and the market is underpinned by good fundamentals. Therefore, the downside is limited.

– Zinc prices moved back close to their cycle lows on Aug. 2, but the weaker U.S. dollar means smelters are even more vulnerable than they were back in November 2001.

– Gold prices recovered late in the week, but overall the performance was poor. The dip below US$300 per oz. coincided with weakness in equity markets and the U.S. dollar. We expect prices will soon move back below US$300 per oz.

The markets continue to make evident their negative judgment on the state of the U.S. economic recovery, with base metals prices approaching the lows of last November. The dramatic fall in U.S. equities and low levels of consumer confidence are feeding through the metals consumption pipeline, so that end-users are keeping their raw-material order levels to the minimum required to service their immediate requirements. This, in turn, is preventing the restocking boom typical of previous recoveries.

The question now is: Has that surge in demand simply been delayed or is the weakness in equity markets going to have real economic effects and produce another dip in final demand. One worrying aspect of the current recovery is the strength still evident in key U.S. end-use sectors for metals, such as transport (monthly U.S. auto sales in July were at their second-highest level ever) and construction. Increasingly, the view is that there is limited upside potential in these sectors but that the risk of big falls to come is growing. Much of the growth in metals demand in Asia (the only major region to achieve year-over-year growth in metals demand in the first half of 2002), is being driven by exports to the U.S. and so is also highly vulnerable. We now know that the gradient of the U.S. economic slowdown was steeper than previously thought, but the shape of the recovery is looking less and less likely to match it.

Copper prices continued on a downtrend, falling sharply even as stock markets made some impressive, if temporary, gains early on in the report period.

While share prices and the U.S. dollar appear to have benefited from some short-covering ahead of holidays, no such benefits were evident in the copper market. Not only was fresh speculative shorting the key factor in copper’s descent during the week under review; the weight of selling has almost certainly pushed the net short speculative position close to its November 2001 peak, suggesting that the market is vulnerable to good news — though it is currently difficult to see where that may come from. One possibility is a resumption of large-scale Chinese strategic buying. Prices on the London Metal Exchange are now back at levels where an initial 200,000-tonne tranche was priced earlier this year. Even if this does not materialize, the downside for prices is restricted in the short term since the speculative community is now close to its limits.

Copper prices are at the bottom of the range that is justified by fundamentals and are also heavily oversold on technical indicators; we therefore expect US$1,495-1,500 per tonne to hold in the immediate term. However, we do offer one note of caution in reference to copper’s recent relationship with short-term U.S. interest rates. Two-year treasury yields fell close to their all-time low in the report period, and if these are an accurate gauge of the health of the U.S. economy, then copper prices may well have farther to fall.

From a fundamental perspective, production levels achieved by Corporacion Nacional del Cobre de Chile in the first half of 2002 provided something of a fillip. The combined 68,000-tonne decline in output at the Chuquicamata, Salvador, Andina and El Teniente mines suggest that production cuts are running slightly ahead of the 106,000-tonne-per-year target announced late last year.

The sharp drop in aluminum prices has taken LME 3-month figures back to within US$60 per tonne of last November’s lows. The main bearish factor in this performance was the sharp deterioration in U.S. economic data. While declines in the Institute for Supply Management manufacturing index and weakness in consumer confidence grabbed headlines, it was the decline in construction expenditures (minus 2.2% in June) that proved most worrying for short-term aluminum demand; this is understandable, given that the construction sector accounts for a quarter of all primary consumption in the U.S. Consumers in the states are increasingly uncertain about their medium-term demand prospects, and they’re likely to continue living hand-to-mouth. Also, now that the market is at its seasonal low-point, the rate of LME stock accumulation is accelerating (plus 24,275 tonnes during the report period). However, current price levels are already discounting a significant build in LME stocks over the next few weeks, and with non-U.S. consumer forward-buying increasingly evident on price dips, we expect support at US$1,310-1,315 per tonne to hold, at least in the short term.

Thereafter, the path of aluminum prices will depend very much on the strength of any demand recovery. Given the dramatic acceleration in output already evident this year, demand will have to grow extremely fast to absorb supply growth. Recent Chinese production data show that growth has exceeded expectations (plus 25% in the first half of 2002, year over year, and plus 36% in June, year over year), pushing global primary output in June to almost 7% above year-earlier levels. In this context, Alcoa’s announcement that it will curtail output at its Badin smelter in North Carolina, cutting around 80,000 tonnes from its annual production, does not count for much. Perhaps of greater significance is the company’s decision to dismantle the 121,000-tonne-per-year Troutdale smelter in Oregon — a clear signal that high-cost smelting capacity is not viable in the northwestern Pacific region of the U.S.

Nickel prices are currently reflecting the recent reassessment of global demand expectations. The fund liquidation that recently pressured the LME complex lower has provided much of the downside pressure and shifted the price support base down to US$6,600 per tonne. Moving down the price line on the nickel chart, the next key area of support emerges in the US$6,400-per-tonne area. Were this level to be breached, however, risks of an even steeper slide down to US$6,000 per tonne would increase significantly, closing in the chart gap that developed in early March of this year. Could prices reach such a low level?

Although upside price risks in the rest of the complex are subsiding in response to the poor U.S. economic data, downside price risks have also eased significantly since the price collapses of the previous week. Recent attempts to shift nickel prices below US$6,600 per tonne have been quickly countered by price recoveries and a return to the US$6,800-per-tonne area. Clearly, this skittishness reflects thin volumes and the start of the European holiday month, and cannot be taken as an absolute indicator of the strength of the nickel market. In a notoriously volatile market, however, the trading funds operative in nickel will also be cautious of the decreased risk-reward ratio associated with building significant short positions. Fundamentals also caution against overestimating nickel’s downside risks. The U.K.-based stainless steel consultancy group, MEPS, is predicting the highest level of Western stainless steel production on record, with output growing by 3.5% to 18.6 million tonnes. During the first half, output is estimated to
have increased by 6%, year over year. Supply developments are also supportive, given the continued problems at pressure-acid-leach operations. The latest production data from Anaconda’s Murrin Murrin plant in Western Australia show improvements. However, although second-quarter nickel production increased 7%, compared with year-earlier levels, to 5,049 tonnes, that is still well below capacity.

Zinc prices reached our short-term price target of US$860 per tonne. Although prices briefly dipped below this level in November and December of 2001, it is still considered a watershed for zinc prices as it effectively marks the lowest trading area in the history of the current zinc contract on the LME. Clearly, the drift lower in the rest of complex is unsupportive, as is the latest series of data from the U.S. A stock increase earlier in the week of more than 33,000 tonnes set the bearish tone and reflected the slackening in physical demand associated with the holiday season. However, the price prospects for zinc going forward will be determined by the factors that have brought prices to such a low ebb, namely, the fundamentals of supply and demand. Although a firmer stainless-steel sector has provided some encouragement, overall demand expectations have been tarnished by the weakness of manufacturing indicators from the U.S. This therefore leaves the supply-side of the equation to provide some corrective medicine. Although the weaker U.S. dollar aids non-U.S. consumption rates, it also increases the risks of cuts in refined production and a correction, at least in part, of zinc’s large supply overhang.

From a non-U.S. consumer’s perspective, a weakening greenback acts as an incentive to make purchases of a U.S.-dollar-denominated commodity as prices in local currencies fall. Right now, however, the elasticity between price and demand is not the key problem of price determination in zinc. Low demand is the product of the current weakness in the global manufacturing base, not a result of elasticity. But with most key producers of zinc based outside the U.S., there is a key relationship between suppliers of zinc and the value of the U.S. dollar: the stronger dollar lowers smelting charges and therefore acts as a disincentive to produce. In a low-price environment, cost sensitivities become more acute, and the differential for zinc smelters between cost of production and price received begins to close. While the fall in the U.S. dollar may be good for consumers, in a low-demand/ high-supply environment, it is detrimental to producers and may hasten production cutbacks.

It’s interesting and telling that the fall in the gold price to below US$300 per oz. coincided with a week of dismal U.S. economic data, renewed downside pressures on the U.S. dollar, a reversal in the Dow’s strength, and the release of second-quarter financial results from some of the major gold producers which showed aggressive reductions in hedge books taking place in the three months to June. These are the ingredients that gold price rallies are made of. Instead, however, we saw a fall to the lowest level since mid-April — and this after the previous week’s US$25-per-oz. freefall.

Regular readers will be aware of our consistent skepticism about gold’s chances of sustaining a move above US$300 per oz. Leaving the fundamentals of the market aside for a moment, let us stress that our skepticism is based on the reported reasons for the rally in the first place. The belief that gold prices have been responding to the Sept. 11 attacks, increased demand from private investors in Japan, equity fault lines and U.S.-dollar risk reassessments is not totally unfounded. However, viewing the gold rally wholly in relation to these “surface” events ignores the much stronger undercurrent of corporate positioning and hedge-book restructuring.

AngloGold’s hedge reduction of 2.4 million oz. would, under any other circumstances, be a bullish event for the gold market. It was greater than the expected reduction of 1.7 million oz., it removed a significant number of ounces from the market, and it accounted for more than 160% of AngloGold’s second-quarter gold production, effectively turning it into a net buyer. Furthermore, AngloGold is in good company. The common thread running through most gold producers’ financials and web sites is the theme of hedge reduction and gold price exposure. However, as stated previously, we suspect that such statements and actions are aimed more at increasing the companies’ market capitalizations and less at improving the gold price outlook. After all, if producers are eager to reduce existing hedged positions as aggressively as possible, would it make logical sense to “pre-announce” this and therefore increase the cost of doing so?

The most telling backdrop to the gold price is not the macro- economic environment we are now in; it is the micro-economic environment the gold price has been in. This environment has been dominated by the theme of consolidation and all that that implies — firstly, for the merger of hedge books, and secondly, for their inevitable restructuring. The restructuring of a hedge book moves the price risks to the upside even without vociferous announcements from producers, and this, in turn, shifts producers’ share prices to the upside. The important condition, however, is that producers are — and are seen to be — exposed to the increase in the gold price. In a predatory and consolidation- oriented environment, the protection of the share price is paramount for corporate survival. A glance at the relative growth of producers’ market capitalizations indicates the growth of the “unhedged” in this department.

The most recent response of the price of gold suggests that, as an issue, it is becoming desensitized and losing its potency. If gold is left once again to trade on its own fundamentals, risks of further price climbs should begin to weaken.

— The opinions presented are the author’s and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be sent to the author at kevin.norrish@barcap.com